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Ratio Backspreads are an option strategy utilized when you believe there will be a spike in volatility in the stock but are not 100% sure whether it will go up or down. This trade requires movement in either direction, preferably in this case to the upside. This trade only loses if the stock sits in a tight range, but even then the losses are minimal because the options hold premium.
Call Backspread: Bullish
The backspread position used when you are bullish on the stock is known as a Ratio Call Backspread, since call options are used to create this position. The call backspread is created by buying a bigger quantity of Out-Of-The-Money (OTM) call options (i.e. call options whose strike price is higher than the current stock price), and selling a smaller number of In-The-Money (ITM) or At-The-Money (ATM) call options (i.e. call options whose strike price is lower than the current stock price). You can create a call backspread by buying and selling any number of call options, in any ratio creating a credit. See the example below.
We are creating a credit position because we are selling an ITM call option, and buying 2 OTM call options. This backspread is going to allow us to collect a premium. Since we are selling an option, we can’t let our position expire. You’ll need to buy the call option you sold, and I’ll now explain the risk involved with this kind of backspread.
Because you are selling a call option that is ITM and buying 2 call options that are OTM, this position should be a credit position; that is you is you will earn a premium by opening a call backspread. If this trade goes in your favor, you will close the trade by buying back the short options and selling the long options for a profit. If the trade goes against you and neither option is in the money the trade will expire worthless and you will keep the credit. However, if the short option is in the money you will need to buy the short option back. The position will expire worthless if the price of the stock falls below the price of the option you sold. So, if the stock price falls below the ITM price, you don’t have to do anything.
Unlimited Profit Potential
The call Backspread profits when the stock price makes a strong move to the upside. There is no limit to the maximum possible profit.
Limited Risk
Maximum loss for the call Backspread is limited and is taken when the underlying stock price at expiration is at the strike price of the long calls purchased. At this price, both of the long calls expire worthless while the short call expires in the money.
Put Backspread: Bearish
The Put backspread position used when you are bearish on the stock is known as a Ratio Put Backspread, since put options are used to create this position. The Put backspread is created by buying a bigger quantity of OTM Put options (i.e. Put options whose strike price is lower than the current stock price), and selling a smaller number of ITM or ATM call options (i.e. PUT options whose strike price is higher than the current stock price). You can create a Put backspread by buying and selling any number of call options, in any ratio creating a credit. See the example below.
If the stock moves above the strike price of the ITM put option you sold, you can allow the position to expire and keep your original credit premium, since all 3 put options will be worthless. If the stock price ends up between that ITM strike price and the strike price of the 2 OTM put options you bought, then you will incur a loss, since you will need to buy back the ITM put option which is now worth something, but the 2 OTM put options are still worthless. Once the stock price drops below the strike price of the OTM put options, you will start to see unlimited profit since the cost of buying back the ITM put option is more than offset by the profits from selling the 2 OTM put options.
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